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An inflation swap is a financial product that transfers inflation risk between parties. These swaps are part of the broader class of inflation derivative products, which includes any product whose value is based on the inflation rate. An inflation swap is a linear inflation derivative, which means that, regardless of the inflation level, a change in the inflation rate corresponds to a particular change in the value of the swap. Investors use these products to buy and sell inflation risk to speculate or protect themselves from changes in the inflation rate. Some entities write inflation swaps to fund other investments that have similar risks associated with them.
Inflation risk is the risk associated with fluctuations in the rate of inflation. Investors worry about increased inflation because it cuts into real returns. For example, if an investor buys a bond, he expects to get the face value of the bond when it matures. If, for example, he pays $900 US Dollars (USD) for a bond that matures in one year and has a $1,000 USD face value, he is expecting about an 11 percent return. If inflation is 2 percent, however, the face value of the bond is only 1,000/1.02 = $980.39 in terms of the dollars from the year before, so his real return is only about 9 percent.
The investor could create a maximum inflation rate by participating in an inflation swap. He would agree to pay a fixed rate on some principal sum, and in exchange another party would pay him the inflation rate on the same principal. The inflation rate that determines what is paid in these swaps is generally based on the Consumer Price Index, or the CPI, which tracks the change of the price of a basket of goods over time. How the inflation payment is determined depends on the type of inflation swap.
Many inflation swaps are zero-coupon, which means that sums of money are exchanged only at the end of the life of the swap. These are commonly two-year or five-year swaps, and the inflation rate is cumulative over the entire period. Some swaps have coupons, which means the parties exchange payments at the end of set periods, which can be every month or up to a year. The inflation rate payment is determined according to the annual, or year-on-year, inflation rate.
Investors might choose to buy inflation swaps if they are afraid of increased inflation and they want to lock in a particular rate. They then face the risk of a decrease in inflation, which makes them worse off. Sometimes, institutions like governments that have products whose costs depend on inflation write inflation swaps. They know that the return on the swaps will be proportionate to the costs of the projects, so they can fund the projects using the revenue stream from the swaps.